“Millennials are quitting jobs to become crypto day traders”
This was the headline on USA Today, Aug 12th, 2021. There were plenty more
stories like this one as a broad swathe of financial assets were buoyed by favourable
economic, monetary and fiscal conditions. Arguably cryptos were the largest beneficiary of
all this free money sloshing around looking for a home, whatever that home might be. By
November 2021, Bitcoin had peaked above $68,000 and crypto traders were rolling in digital
cash. JPEGs NFTs were changing hands for
staggering amounts. Many had flipped their attention to cryptos – some for the first time –
following the meme stock craze of earlier that year. Many had already made money in crypto
and then more as they followed the WallStreetBets thread on Reddit. That had been the first
real mania for markets following the deluge of fiscal and monetary stimulus that saw a vast
surge in the creation of new money during the pandemic. 
It all seemed to be going one
way. Cryptos, like ‘stonks’, only went up. Then along came the Federal Reserve and a giant
rug pull. A lot of factors contributed to the collapse in LUNA, but at the heart of the
decline in the broad crypto space is due to the US central bank pivoting away from
max-accommodation to an aggressive tightening cycle. Bank of America last week noted that
the crash in crypto and speculative tech now rivals internet bubble crash (Nasdaq -73%
peak-to-trough) & GFC (banks -78%). It notes that the meltdown in crypto assets has been
the result of a combination of Nasdaq unwind, low liquidity, pool migration and whale
attacks. Last week Bitcoin sank below $27,000, for the first time since 2020 – an important
psychological level. It doesn’t mean the party is over but there are plenty of wounded
soldiers out there.
‘Crypto winter’
One problem that many will understand
instinctively; a drop in trading activity and a decline in liquidity, which is making the
market more susceptible to large swings. Trading volumes at leading exchanges have
plummeted, with Coinbase reporting a 44% decline in the first quarter. Overall notional
trading volume fell to $309 billion in the first quarter, down from $547 billion in the
fourth quarter. Monthly transacting users (MTUs) fell to 9.2 million, down over 2m from 11.4
million in the fourth quarter. It’s not just the US – volumes at four Indian venues
collapsed since April 1st, the day a new tax on crypto profits came into effect.
Chart: Crypto trading volumes are much lower than their peak during the bull market of
2021
Correlation
Increasingly, correlation between risk
assets and cryptos is tight. Portfolio stress is being felt across assets; as one falls it
creates a negative feedback loop on other assets as margin calls need to be met and models
call for de-risking. So, when crypto declines, stocks can be upset. And the speculative tech
bubble being pricked left cryptos highly exposed. This is partly to do with the very
institutional interest that had been touted as a positive. Unlike Bitcoin bros and HODLers,
the banks and various institutions are not prepared to be bitcoin bag holders – they
deleverage quickly, and Value at Risk models will always point to the most volatile assets
as being the first to be sold during a downturn. 
Institutionalized
According to Morgan Stanley, “retail
investors are no longer the dominant crypto trader”. A third of trading volumes on Coinbase
was retail in 2021, down from 80% in 2018 “The largest proportion of daily crypto trading
volumes is from crypto institutions, much of which comes from them trading with each other,”
says MS, referencing institutions such as exchanges, custodians, and crypto funds. It goes
on: “Retail traders were dominant around four years ago, when bitcoin traded below $10k. We
think
the increased involvement of institutions, which are sensitive to availability of
capital and therefore interest rates, has contributed in part to the high correlation
between bitcoin and equities.”
Of note, whilst MS says interest
rates are a factor, it suggests the rise in the money supply (see chart 1 above) is more
important. This means that crypto could be even more susceptible to quantitative tightening
than other assets. Cryptocurrencies are “more sensitive to the money supply than changing
interest rates”, says the bank, adding: “Crypto prices rose in 2020 and 2021 due to central
banks increasing fiat money supply […] Now the Fed is tightening, crypto and equity markets
are correcting lower.” As is so often the case, it’s a question of liquidity, and the Fed is
reducing it. MS continues: “The times of ample
liquidity are truly over. Speculative risky assets, like cryptocurrencies,
have repriced lower as their higher prices (relative to 2019) had been justified by ample
USD creation. The correlation between bitcoin and equity indices has remained high and will
continue to do so unless bitcoin becomes widely used as a medium of payment – which looks
unlikely to happen soon.” Indeed, Sam Bankman-Fried, the founder of exchange FTX, told the
Financial Times recently that Bitcoin won’t work as a payments network, because its “proof
of work” system cannot handle millions of transactions. Such arguments are hardly new.
Bitcoin has never looked viable as a payments network, or a de facto private money. But they
are important as they come from a leading crypto billionaire. It all suggests that far from
revolutionising money, currencies and payments, Bitcoin and so many other cryptos that
depend on it for sentiment will remain speculative, risky assets. Which means that while
trading volumes are down today, and crypto traders are in hiding, they may not remain so if
Bitcoin can rally and drag the rest of the market with it.